Brexit uncertainty and global trade tensions are hitting UK growth, with the Bank of England's forecasts showing a one-in-three chance that the economy will shrink at the start of next year.
In its August inflation report the bank cut its central forecast for growth this year and next, predicting output would rise just 1.3 per cent in both 2019 and 2020 even if it were to cut interest rates as markets have been expecting. The Bank of England had previously forecast in May that output would grow 1.5 per cent and 1.6 per cent respectively.
It added there was a 33 per cent probability of negative growth in the first quarter of 2020 if interest rates remained unchanged – the highest chance of a contraction it has seen since the immediate aftermath of the Brexit referendum in August 2016.
Mark Carney, the Bank of England governor, dismissed suggestions that it was guilty of adopting the "gloomster" attitude decried by new prime minister Boris Johnson.
“It is clear the level of uncertainty is affecting business,” Mr Carney said. “It is also clear there has been a substantial shortfall in investment. It is beginning to become clear that the trade response to lower sterling has begun to fade . . . these consequences are there.”
But in contrast with the US Federal Reserve and European Central Bank, the Bank of England shows no signs of responding to the weakening outlook by cutting interest rates. Instead, the monetary policy committee (MPC) voted unanimously to hold rates at 0.75 per cent, and signalled that borrowing costs would eventually need to rise to keep inflation at its 2 per cent target – given an orderly Brexit and a recovery in global growth.
It also stuck to its collective position that interest rates could move in either direction in the event of a no-deal Brexit.
Strong rebound
The bank’s central forecasts, premised on a smooth Brexit that would boost the economy, show inflation overshooting its target by a significant margin, rising to 2.4 per cent on a three-year horizon. The forecasts also show a strong rebound in growth, which rises to 2.3 per cent in 2021 – above the May forecast.
However, the bank acknowledged that these forecasts were of little practical use at present since they are built on the prevailing market exchange rate and on market expectations of the path of interest rates.
In contrast with the Bank of England, investors are factoring in an increasing risk of a disruptive Brexit. They have assumed that policymakers would respond to this by cutting interest rates, with a quarter-point increase priced in by the end of this year. Both this, and the recent sharp depreciation in sterling, result in a higher forecast for inflation.
Since Mr Johnson entered Downing Street last week, he has instructed ministers and officials to “turbocharge” no-deal preparations, and on Thursday the chancellor Sajid Javid announced £2.1 billion (€2.3 billion) in extra funding to prepare for the UK crashing out of the EU on October 31st.
The MPC has declined to set out any alternative forecasts based on a less benign outcome, saying that a deal with Brussels remains official government policy.
But the August inflation report includes alternative projections showing what would happen to inflation if a Brexit deal led markets to take a more optimistic view of the economic outlook.
Excess demand
The MPC said that although growth and inflation would be lower in these scenarios, there would still be excess demand, fuelling inflation, in any orderly Brexit scenario – suggesting that interest rates would still need to rise to keep inflation on target.
Some economists said that despite this hawkish language, the bank’s scenarios showed inflation would remain close to target even if interest rates remained on hold.
Assuming a 5 per cent rise in the trade-weighted value of sterling, and a market path for interest rates quarter of a point higher than at present, inflation would be just above target at 2.1 per cent in three years’ time, the projections show.
With a 10 per cent rise in trade-weighted sterling, and a 50 basis point increase in rates, inflation would be below target at 1.8 per cent.
However, since much of this would be due to the temporary effect of a strong pound, the Bank of England believes excess demand would still be stoking domestic inflationary pressures. – Copyright The Financial Times Limited 2019
